After traders get past this tricky Fed meeting, a confusing second half awaits

This will be a very tricky Federal Reserve meeting for traders, but it won’t be much easier even after the gathering.

Even if the Fed adopts a best-case, stay-the-course-on-tapering-and-rate-hikes scenario at the end of its two-day meeting Wednesday afternoon, the market has a big problem: Traders don’t know where we are in the economic cycle.

Inflation hawks are on the rampage. Inflation is running above the 2% target, which is what the Fed wants. Will the recent stronger-than-expected inflation reports force the Fed to hike rates sooner than expected? In March, all 18 policymakers expected no rate hikes this year; four expected hikes in 2022, and seven said rate hikes would not come until 2023.

Inflation hardliners are insisting that should change, with more anticipating rate hikes sooner.

But many on the Street still don’t believe it.

“Some of this hawkish expectation is way overblown,” said Michael Arone, State Street’s chief investment strategist for the U.S. SPDR business. “Powell is going to say the labor market has 7.5 million jobs to go before it gets back to where it was.”

Many other strategists agree, pointing out that the key to understanding Fed Chairman Jerome Powell’s mindset is to understand his fixation on improving the labor market at all costs, even if inflation runs higher than anticipated.

“We think that Powell likely agrees with Governor Brainard and President Williams that the labor market has not yet come far enough,” Goldman’s Jan Hatzius said in a recent note to clients. Hatzius believes the majority of the Fed will continue to indicate a rate hike will not come until 2023 but admits “it is a close call.”

In a recent note, Citigroup’s Tobias Levkovich cited several other catalysts for a potential market pullback in the second half of the year. “When we look at the possible catalysts for a pullback in stock indices, we continue to think that any hints at tapering, or profit margin misses, more persistent inflation spikes, as well as taxation dynamics can all come together and be a greater force than if only one of these items emerged,” he said.

He singled out the chances that profit margins might erode. “Profitability seems set to be squeezed by rising input costs that will not immediately be offset by price increases,” he said.

The biggest debate investors are having now is the “peak everything” (peak earnings, peak economy) story and a variant on that story — where are we in the economic cycle?

Answering that question will determine what type of stocks to own, or even if stocks are desirable at all. Are we still in the early stages of a broad economic expansion that will go on for a year or more, as some bulls have claimed? Are we in the middle stages? Or are we in the later stages, where growth will quickly decelerate?

Getting the answer right matters because investors are taught to buy and sell certain sectors depending on what stage of the economic cycle we are in.

For example, if the economy is still in an early stage of the economic expansion, investors would typically buy cyclical (value) and bank stocks, as they have been for most of this year. If the economy is in the middle of the recovery, where growth and earnings are still strong but beginning to decelerate and interest rates are still low, many would then favor technology stocks. If we are in a late-cycle phase, which is characterized by higher rates and higher inflation and high price-earnings ratios, investors would typically favor defensive sectors like consumer staples.

The problem is, no one is sure what part of the economic cycle we are in.

“For investors who are trying to align with an economic cycle, it’s been really challenging,” Arone told me, noting that there is considerable confusion over whether the trend in rates and inflation are up or down.

All that is hard enough to figure out, Arone said, but “when you add in the distortive effects of fiscal and monetary policy coming out of the pandemic, I don’t think anyone knows where we’re at.”

Jim Paulsen, chief investment strategist at Leuthold, agreed, citing the head-spinning change in the economy due to the pandemic and the Fed’s actions.

“We went from a depressionary bust to a boom in a matter of months,” he said. “We went from the weakest year on GDP growth, to the fastest GDP growth. We’ve never done anything like that. Some think the Fed’s policy will put us into a boom era, some think it’s going to send us back to the 1970s with rampant inflation. No wonder there’s confusion.”

The key question, Paulsen says, is “are we entering a new era of higher GDP growth of, say, 3%-4%, or do we fall back to growth of about 2%?”

Bob Shea, CEO of TrimTabs, agrees that the market is confused about the economic cycle. “My gut tells me that we’re midcycle, but my thinking is that when they [the Fed] do start tightening, we go pretty quickly to a late cycle. It’s a function of all the distortion. So the duration of this midcycle activity might be a little shorter than usual.”

Shea, however, is not concerned that the Fed is imminently going to change its stance, and neither is Arone.

“If the labor market comes roaring back at the same time inflation numbers are high, then the Fed’s got to do something, but until we get there, I think they’re going to grip firmly to the transitory narrative, and they’re going to stand pat,” Arone said.